Bold Projections Taken Out of Context Overstate China’s Leeway for Military Budget Growth

The UK’s long-established International Institute of Strategic Studies (IISS) recently published a Military Balance 2013 report which makes some reasonable observations about the current state of global affairs, but unquestioning media parroting of some of its talking points invites more scrutiny. Namely, one of the report’s charts puts Chinese defense spending possibly above the US within a dozen years, and continues to project current spending trends until 2050, in current dollars, with today’s exchange rates. Unfortunately, if this is taken at face value as a prediction, it’s misleading and pointless…

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Constraints Matter

By the middle of the century both the US and China will have markedly aged, putting a significant strain on public finances and military recruitment. The underlying funding variables will need significant adjustments way before 2050. In the shorter term, US Administration budget projections – which are not worth much in the first place – don’t commit future governments, and will be forgotten within years not decades. US President budgets are part of a 5-year plan (known as the FYDP) which gets revised all the time. If future Chinese military spending were to boom as in the chart, it seems very unlikely that the US will just continue to operate off an old budget baseline (in 2030, what’s so special about the FY12-17 FYDP anyway?), for several decades, under many different Presidents and Congresses.

The bottom line is that you can’t take today’s set of variables as if they were constants, then stretch that data 40 years into the future as if nothing will change.

What’s much more likely is that China’s military spending will reach Western Europe’s within a decade, which would already be pretty significant in its own right. There is no denying that China has been sustaining a well-funded but opaque military build-up, standing out within a region that has been growing its spending [PDF] markedly. However, unless they switch to a war economy or replace the US as the world’s sole superpower, there’s no way China is going to sustain, for decades, their past 15.6% annual compound growth rates (i.e. doubling every 5 years!), all from much higher levels in absolute terms, while its GDP grows at maybe half that rate in years to come.

Notice how the solid red line showing China spending $2.5B in 2030 is not drawn further. Obviously, at some point growth has to slow down.

Hard Today, Harder Tomorrow

Under alternate scenarios in its chart, the IISS also models more reasonable growth for a while, but then comes a return to ballistic growth as of in 2031. Surely, to generate these assumptions, the think tank already knows something about what will happen then that we don’t. Martian threat?

More seriously, to clear up what is supposed to happen in 2031, we talked with Giri Rajendran, a Research Associate for Defence & Economics at IISS who walked us through the assumptions built into what he insisted should be seen as a thought experiment without predictive pretense. Rajendran argues that the double-digit growth seen in past years shows the intent of the Chinese authorities, and the slower growth modeled until 2031 is his way of letting China transition out of its current investment / export model, towards something that gives more room to local consumer consumption. Their Western customers have stalled economies, so the mercantile model cannot continue to grow at its past pace. Meanwhile, many observers say the capital investment model is unsustainable, leading to empty malls and ghost cities. Once China has done that generational rebalancing, they can resume the full pursuit of their military ramp-up.

That makes sense, but two decades from now China will also face serious demographics constraints that are already baked in today because of its one-child policy, which a little bit of recent easing is not going to fundamentally revert. Unless China goes back to 18% per year GDP growth in the future – which is not what Rajendran or any one else claims – it stands to reason that to grow 15+% a year for years on end in the 2030s-40s, the military would have to crowd out increasing demands to fund massive retirement, healthcare and environmental clean-up needs.

Even taking for granted that the Communist party will still have a firm grip on the country in twenty years, they are already facing internal limits to their power, which may be authoritarian but is not absolute. China will have a harder time increasing its relative military spending then, not an easier time. Harder when it confronts developed country issues without being one, than it does now when it still has high growth, and a relatively young and compliant population.

China may overtake the US as the world’s biggest economy way before 2050, so in principle they could find the room to surpass the American budget. But they still face huge developing world constraints, and have a much bigger population to placate. If China can’t stomach 16% defense growth this year or the next, how are they going to be able to do so in 25 years when they look like a bigger, poorer, dirtier Japan?

Barring a massive conflict – in which case all bets are off – a relatively slow but converging creep over half a century looks more likely, more as a byproduct of Chinese GDP growth and Western/ European complacency rather than a sudden massive rush from China.

Finally, long-term inter-country military spending comparisons also need to take into account factors such as respective inflation rates and purchasing power parity (PPP), if their goal is to inform rather than inflame. But good luck producing a PPP-adjusted chart in constant dollars (i.e. also inflation adjusted) of international defense budgets that will prove even remotely accurate over more than a decade.

There are too many interlinked unknowns at play feeding back into each other. Will China let its currency float? Will the US Federal Reserve continue to actively debase the US dollar through seemingly limitless asset acquisitions, faster than other central banks are able or willing to? Will Chinese growth stall or stay in the 8%-12% range? Will its growing middle class demand much higher wages and better living conditions such as air you don’t have to munch before inhaling? Will China’s efforts to undermine the US dollar as the world’s reserve currency, itself a big source of US military supremacy, gain traction?

If you have the answers, you should run a macro hedge fund.

Think Tanks Should Know Better Than Invite Media Malpractice

Giri Rajendran is well aware of market rate vs. PPP subtleties, and he readily acknowledges these feedback loops and the high degree on uncertainty involved in such an exercise. And he has a good point when he asks: “Who would have predicted in 2000 that China would spend in 2012 more than Japan, South Korea and Taiwan combined?” This one chart should not be interpreted without taking into account a bunch of footnoted caveats. Our point is that complex issues deserve more than linear projections working in a vacuum, that the 24-hour news cycle then hurries up to further simplify and amplify into dramatic forecasts and attention-grabbing headlines.

It’s understandable that media-savvy think tanks package their research in a way that will give them media exposure, but they also have a responsibility not to release material that can easily be poorly-interpreted and sow confusion, rather than understanding.

Note: We have not seen the full report. IISS graciously offered to send us a hard copy but that was not compatible with our deadline, and an electronic copy was not available.